Taking stock of markets

It may be the dog days of summer but financial markets are still busy as we digest the implications of the dramatic second quarter earnings season. Latest estimates suggest that more than 80% of the S&P500 companies reporting so far have beaten earnings expectations, although this has a lot to do with companies issuing very pessimistic guidance in a bid to ensure a positive surprise and hopefully a boost to equity prices. It is an old trick but it seems to work and one of these days investors will get wise to it. Nonetheless, it has helped equity markets along with the S&P500 now just 1% shy of its mid-February peak.

Regular readers will recall I expressed concerns prior to the March sell-off that equities were overvalued. You might therefore think that the recent rebound is a cause for concern. But I am less concerned about the recent rally than I might once have been. For one thing, although risk indicators such as equity option volatility continue to edge lower, the VIX is still trading above its long-term average. It is notable that the VIX has come off its mid-March high of 83 to current levels of 22 (long-term average: 19.4) far more rapidly than in the wake of the 2008 collapse when it took 13 months to fall from the September 2008 high around 80 to levels around 22. This is one illustration of the impact that central bank liquidity provision has had on markets. In 2009 it took a while before markets realised that central banks were serious about ongoing liquidity provision. A decade on, markets have accepted the message that central banks mean what they say about providing all monetary support necessary and are investing accordingly. With no sign that central banks are about to pull the punchbowl, the liquidity support underpinning markets will be in place for a while.

Indeed whilst it is easy to make a case that prices are out of line with fundamentals, an environment of zero interest rates renders conventional metrics such as price-to-earnings or price-to-book ratios meaningless. This appears to be a market where investors feel they need to be invested in order to get some returns – after all, dividend yields continue to look attractive. It is possible that investor positioning will change once fund managers get back to work after the summer break, which is one reason why we see so many equity crashes in the autumn. But it is difficult to see where else investors can put their funds to work for a better return.

For all that equities might appear excessively valued, estimates of the equity premium are on the rise. The ERP reflects the required excess return over and above the risk free rate and past experience suggests it declines at a time when investors become less discerning about what they buy. On my estimates, which assume long-term dividend growth rate of 3.6%, the UK ERP is running at 820 bps. This is slightly down on the March peak of around 920 bps but is nonetheless high in the context of the past 25 years (chart 1). To a large degree, the rise in the ERP reflects the fall in bond yields whilst investors have not yet adjusted down their required earnings in view of the changed macro environment. Indeed, in a world in which trend GDP growth is lower due to slower population growth and limited productivity growth, and in which the Covid crisis will impact on earnings, so expected equity earnings are likely to adjust downwards. It appears we are in a world where investors expect a return to some form of “normality” as the current crisis passes. But just as the 2008 crash pre-empted a change to a new normal in the equity world, so Covid may be the catalyst for a “new, new normal.” Bottom line: Look for the ERP to edge lower in the medium-term.

However, we cannot afford to be complacent. Mounting fears of a second Covid spike, which could impact on the economy, and rising geopolitical tensions are good reasons for investors to raise the weight of safe assets in their portfolios. Nowhere is the flight to safety more evident than in gold where the price has established a new record in recent weeks above $2000/oz. I do have some concerns about how much further it can go. According to the World Gold Council, there were record flows into exchange traded funds over the first half of the year. To the extent that ETFs represent shadow demand for gold, and to the extent that a change in risk perception could see a sharp reversal of investor positions, there is a nagging sense that we are operating in elevated territory. That said, as with equities, there are no good reasons to expect an imminent downturn. After all, one of the conventional arguments against holding gold is that it is a non-interest bearing asset. But so, too, is cash these days. If the opportunity cost of holding gold is effectively zero it makes sense to overweight it in these turbulent times.

As a final thought, I have read a lot recently suggesting that investors’ fear of inflation as a consequence of recent central bank liquidity provision is one of factors driving gold higher. But evidence in support of the view is lacking. The break-even yield on 5-year Gilts, which reflects the difference between yields on conventional and index-linked bonds is currently running in negative territory at -8bps versus 60 bps at the start of the year (chart 2). Even the 10-year breakeven is trading at just 13 bps. To the extent that the breakeven rate reflects expected inflation over the lifetime of the bond, the data suggests that investors currently fear the current crisis will be disinflationary – or even outright deflationary – rather than adding to price pressures. In my view, the gold price surge reflects ongoing global uncertainty. It makes sense after all – an unprecedentedly high gold price reflecting unprecedentedly uncertain times.

The storm before the tsunami

To say it has been a wild market ride today would be an understatement. Based on daily data back to 1985 (a total of 9179 observations) the 7.7% decline in the FTSE100 is the fifth largest correction in recent history, beaten only by double digit declines in the wake of Black Monday in 1987 and two days of correction in October 2008 as the Lehman’s fallout continued to reverberate. The 7.9% decline in the DAX was also the fifth largest correction in the German equity market although the US correction did not even make the top 10.

I have been through a few market corrections in my time, and each of them was triggered by a unique set of circumstances. Today’s moves, however, were only partly initially related to equities. They were triggered by the 30% collapse in the oil price following Saudi Arabia’s decision to launch an oil price war and were exacerbated by coronavirus concerns. The Saudi decision came after Russia refused to join OPEC countries in extending existing production curbs in a bid to drive oil prices higher and the Saudis are clearly trying to force the Russians back to the negotiating table. This is bold and risky strategy. Whether or not it works, the shock decline in oil prices put initial pressure on the oil majors and triggered a broader market selloff at a time when sentiment was already extremely nervous. Momentum effects then took hold as equities competed to go ever lower.

Faced with this kind of environment, there is nothing anyone can do but stand back and watch the carnage unfold. Interest rate cuts will be of no real help, even though the Fed, ECB and BoE are likely to deliver additional monetary easing before the month is out. Policymakers can perhaps impose bans on short-selling or impose circuit breakers on the market which will temporarily limit the downside but they are on the whole powerless. The flip side of the equity selloff has been the surge into safer havens such as government bonds and gold, with the US 10-year Treasury yield falling to a new all-time low of 0.5% and the 10-year German Bund trading at -0.86%, implying that investors are so keen to preserve their capital that they will accept a negative return on their holdings of sovereign German debt because the expected loss of principal is greater than the negative yield on Bunds. Without wishing to be too gloomy, a lot of countries are now apparently at much greater risk of recession than perhaps we thought a week ago.

In the face of an equity correction of today’s magnitude, it is easy to extrapolate into the future and make the case for further huge declines. But much depends on the nature of today’s shock. If it merely represented a kneejerk reaction to the oil collapse which got out of hand, markets could easily rebound a little in the near-term. But if it reflects concerns about the impact of the coronavirus on the wider economy, which is more likely, I would expect a lot more downside before we reach the bottom. I noted in this post that the US market had the potential for another 10-20% downside. The market is already 7% below where it was when I wrote that, and as the number of non-Chinese virus cases continues to increase, the potential for economic disruption continues to grow.

The fiscal response

With monetary policy all but exhausted, governments will have to step up to the plate to deliver measures to support the economy. We will have a great chance to see what the UK government is made of when it delivers its post-election Budget on Wednesday. Much of the very good pre-Budget analysis prepared by NIESR or the IFS has now been overtaken by events. It was originally planned that this would be a Budget which attempts to deliver more spending, particularly for those regions which have been left behind by austerity. This was to be a reset of policy – the so-called “levelling up”. But now it will be dominated by efforts to limit the impact of COVID-19.

There are essentially three areas that the government will have to address: (i) ensuring liquidity-constrained businesses can continue to operate; (ii) providing support for individuals who lose income and (iii) maintain the delivery of public services. There are various things the government can do: In the case of (i) more generous payment terms in areas such as employer social security contributions would help to limit the burden (e.g. a payments holiday whereby firms do not have to pay contributions for those workers who are sick with the coronavirus). To tackle issue (ii), the government could reduce the time it takes to get access to Universal Credit payments (as I argued here) and addressing (iii) might involve significant increases in the budget for the National Health Service.

As the IFS points out, in fiscal years 2008-09 and 2009-10, the government’s fiscal expansion package was equivalent to 0.6% and 1.5% of GDP respectively. That is a high benchmark but the UK does have the fiscal headroom to try something similar today. Other governments across Europe will have to follow suit. The German government, for example, has previously dragged its feet but there are indications that it is now prepared to boost spending to support companies which apply for aid to offset wage costs during labour layoffs. As the UK examples cited above show, fiscal policy does not necessarily have to take the form of big infrastructure spending programmes: tweaks to the tax and benefit system can provide much more targeted help.

The time for waiting is over with action required to at least prepare the economy for the worst case outcomes. There is after all, no point in the likes of Germany continuing to run surpluses for the sake of it. We should welcome any moves towards fiscal easing. For too long, governments have been absent from the fiscal policy fray and have left it to central banks to manage the economy. Whether it will mark the start of a more targeted approach, or whether we will soon revert to a period of retrenchment remains to be seen. But whatever else governments do, they must act soon. If nothing else, markets will ultimately punish them for failing to act.

Reflections on a market rout

Many people have remarked about the end of days feel in the markets. Here in the UK, many regions of the country have experienced unprecedented flooding, with more to come over the weekend, whilst parts of Africa and Asia are enduring a plague of locusts. This is before we even talk of the coronavirus which has gripped the imagination like no epidemic in recent history. 

I did point out at the start of the year that short of an exogenous shock it was difficult to know what would derail the equity market. Such shocks are by their nature difficult to foresee but who would have thought that the catalyst for change in market thinking would have come in the form of something we cannot see but whose presence we are aware of – a veritable ghost at the feast? Equities have just posted their biggest weekly correction since 2008, and having experienced similar corrections in the past, I know the futility of trying to call the market bottom. The extent of market concern can be gauged from the VIX index of implied equity market volatility which has shot up to a level of almost 48 (recall that three weeks ago I expressed astonishment that it was running so low), taking it to its highest level since 2011 (chart below).

Whatever the longer-term health implications, there is clearly going to be a period of intense economic disruption. It could last for days, weeks or even months, but it is clearly going to impact on activity rates at the end of February and into March. Such is the power of the unknown triggered by the virus that face-to-face client meetings are being cancelled as businesses test their disaster recovery procedures; Switzerland has banned gatherings of more than 1000 people, with the result that two major trade fairs including the Geneva Motor Show have been cancelled, and travel restrictions are being ramped up. Naturally this will adversely affect corporate earnings, which explains the collapse in markets over the past week (I would not like to be in the insurance business at the present time). This raised a question in my mind regarding the information content of the equity market collapse for events in the wider economy. After all, investors focus on the slope of the 2-10 curve in the bond market, but is there a corresponding equity indicator?

The information content of market corrections for the real economy

In order to assess the severity of the market collapse we need an indicator which measures both the extent and duration of the collapse. In order to do this, I looked at all trading days since 1940 and calculated those periods when the S&P500 declined for five consecutive sessions, and measured the resulting 5-day change in the index (I excluded the period 1928 to 1939 due to the volatility of the index over this horizon). I reduced the sample still further to select the subset of periods where the fall in the index cumulated to more than 7% (admittedly an arbitrary value). This resulted in 15 episodes (not counting the current one). To put some values on it, I measured the sum of peak-to-trough declines across all such episodes per calendar quarter. For the most part these are zero but in 13 cases there was one such event per quarter and in 1974 and 2009 there were two, resulting in index values of between -15 and -20 (chart below).  

As a leading indicator, the index is by no means perfect. It has provided three false recession signals (1962, 1986 and 2015) and did not foresee the recessions of 1969-70 and 1980. But it did provide useful information in 1974, 2000 and 2008. In this sense it is not that much different from the 2-10 curve which often flashes false recession signals. And it may be possible to improve it by being more systematic about measuring the decline threshold.

It would thus be too much of a stretch to suggest that the equity market is pointing to a recession in the US, but given the expected impact on activity as a result of what has been going elsewhere in the world, some slowdown in growth is likely. Moreover, given the duration of the US business cycle, which is the longest in recorded history, it may also be vulnerable to shocks. One transmission mechanism from the market is the consumer wealth effect. Estimates of this effect vary but a study produced by the IMF in 2008 suggested that the long-run elasticity of US real consumption with respect to equities is around 3.5%. In other words, each one dollar decline in the value of equity holdings will reduce consumption by 3.5 cents. If the market holds at current levels (13% down), this would imply a reduction of around 0.4% in consumption. If this spills over into other assets, such as housing, the impact will be even bigger since the US housing wealth elasticity of demand was estimated at 13.7%.

Is there value out there?

We are, of course, getting ahead of ourselves. Anecdotal evidence suggests that real money investors have not sold off to anything like the extent to which the headline index suggests. If true, it might indicate that the selloff has been exacerbated by algorithmic trading. An academic study published in 2017[1] suggested that the rise of exchange traded funds (ETFs), which are essentially passive investment funds which track the market, means that investors derive “lower benefits from information acquisition”, thus reducing their incentive to undertake it. This in turn reduces the efficiency with which investment decisions are taken and raises the risk that market swings may be larger than would otherwise happen in the event of a market where investors are forced to do their own due diligence. Once the dust settles, regulators will undoubtedly take a closer look at this issue given their mounting concerns over the impact of black-box trading models on market swings.

For now, however, investors are flying blind. Whether the coronavirus effect turns out to be a flash in the pan or a prolonged problem, the time for taking risks is over. As winter slowly gives way to spring, the next few weeks are going to be interesting. There is no doubt that the recent shakeout has taken a lot of air out of the balloon and on the basis of Robert Shiller’s long-run CAPE measure, we are now starting to approach less toppy valuation levels (chart below). This long-run P/E measure is now close to 27x versus 31x before the rout started. But if this is a trigger for a cyclical correction as in 2000-01, there could be another 10-20% market downside as the CAPE heads towards 23x. 

Brave investors will likely step in at some point soon. As Warren Buffett, the grand old man of value investing, once said, “Widespread fear is your friend as an investor because it serves up bargain purchases.” But Buffett also knows the value of waiting until the price is right.

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[1] Israeli, D., C. Lee and S. Sridharan (2017) ‘Is There a Dark Side to Exchange Traded Funds? An Information Perspective’ Review of Accounting Studies (22), pp 1048-1083

Caveat emptor

We have just finished the fifth full trading week of the year, yet it seems an awful lot has been packed into the past 25 sessions. We started with the assassination of Qasem Soleimani which spooked markets – albeit only briefly – and followed this up with the accidental shooting down of a Ukrainian aircraft in Tehran which further inflamed Middle Eastern tensions. The current big source of concern is the coronavirus which prompted a market sell-off last week but which has subsequently been reversed. Add to this the bizarre spectacle of the Trump impeachment, his subsequent acquittal and the travails of the Democrats in Iowa and you have all the ingredients for a classic risk-off market.

But not a bit of it. The US equity market reached an all-time high on Thursday, taking the year-to-date gain on the S&P500 to 2.7%. If it carries on at this rate (which it won’t) we are on track for another 20%-plus gain following last year’s 29% increase. Whilst market measures of implied option volatility are off their recent lows reported at the end of last year, they remain far from elevated (chart above). The VIX measure of equity volatility currently trades at 15.6 versus a long-term average of 19.1. A similar picture is evident in the fixed income market where the MOVE index ended the week at 61.2 against a long-term average of 92.7. Despite the recent increases, the extent to which investors have expressed their concerns about the long-term economic effects of the coronavirus suggests that recent moves look fairly muted in a wider context

Markets have thus looked through the recent concerns and appear to have concluded that the only thing they have to fear is fear itself. To the extent that the initial reaction reflected fear of the unknown, selling was a natural response but now the shock has worn off. However, it feels like the recent equity surge reflects nothing more than a relief rally. And relief rallies can run out of steam. After all, we have no idea what the near-term implications will be for the Chinese economy but it is unlikely to be good for corporate earnings. Reports from China point to significantly reduced activity as people stay at home, either by choice or as a result of state directive. Burberry has already warned about the potential hit to earnings and has closed 24 of its 64 shops on the mainland whilst ripping up its earnings guidance for the current fiscal year. They are unlikely to be alone as companies with significant exposure to the Chinese economy begin to assess the damage (other luxury goods producers and airlines are sectors which spring immediately to mind). Meanwhile, supply chain disruptions might well become more pronounced and as the hit to corporate earnings materialises, so markets will be forced to revise their expectations.

That said, if the situation mirrors the SARS outbreak in 2003, markets will be expecting a big rebound in activity in the second half of the year with the result that they may simply be looking through the (hopefully) short-term disruption. But we cannot be sure what will happen. Consequently it would seem prudent for investors to take some risk off the table. The fact that they are not doing so reflects the great faith they have in central banks to keep markets afloat with exceptionally lax monetary policy. The rational economist in me does not share that optimism, but viewed from the perspective of the market, the absence of decent financial investment alternatives suggests that any market correction is likely to be brief. If you are a forward looking rational investor, this is a good reason to stay in the market because you avoid the transaction costs associated with selling and buying back in again.

Having been burned in the past with regard to calling the market top I am reluctant to do so again. But a market where valuations look stretched is always going to be vulnerable to unexpected exogenous shocks and it may be that the coronavirus effect turns out to be the catalyst for a rethink. Even if it doesn’t – and there are good reasons to believe that much of the current concern is overblown – it should act as a warning sign that good times do not last forever. So far, the fact that the US economy is holding up continues to support the bullish case and although I do not believe that the economy will crack this year, it may pay to dance near the door in order to beat the rush if the stampede begins.

If ever an indication were needed that something is afoot, take a look at the rally in Tesla stock. Investors have shorted it for the last year, believing the company would struggle to deliver on its plans. Yet since the start of the year its price has risen by around 80% and its market cap now exceeds that of Volkswagen (chart above). Such a sea change reflects more than a simple shift in attitude towards electric cars and Tesla’s ability to deliver – that is a bubble waiting to pop. My natural investor caution is based on the premise that if something cannot continue to forever, it will stop. There again, maybe this time really is different. But they said that in 2000 and 2007 as well. Caveat emptor!

2018 in review

As we look back at 2018, many of the bigger trends which I anticipated a year ago did indeed pan out. There were a few unanticipated surprises, of course: It would not be quite the same if there were not. To summarise the year as succinctly as possible, global growth held up although fears of a slowdown began to materialise late in the year; markets had a rocky year and politics dominated the agenda. 

As I noted in early January, markets at the start of the year were entering late-cycle territory with many investors describing themselves as “reluctant bulls.” My recommendation at the start of the year was to reduce the degree of risk exposure, primarily because I expected volatility to pick up, but I still expected equity markets to end the year up 5-10%. I was right about the volatility but wrong about the trend in equities, although I was right to believe that equities could not continue to rally as they had done in previous years. The equity option volatility trend reflects a change in investor attitude towards risk and there was a sharp spike in February and a less elevated but still strong upward movement towards the end of the year. I have long believed that markets were under-pricing risk and 2018 was the year that a reassessment took place. Many of those who were reluctant bulls a year ago are now outright bears, and with hindsight I should have had the courage of my convictions to call for the market correction that I feared might happen.

The reasons for the investor reassessment are many and varied. My main concern a year ago was I believed equities to be overvalued: Based on the Shiller ten-year trailing P/E metric I still believe they are. Cracks in the tech universe were another factor: Tech stocks continued to fly high until late in the year but I did warn that “a market which is so dependent on tech stocks is clearly vulnerable to a shift in sentiment.” And so it proved when the FAANG stocks started to give up their gains around October. This is partly the result of product dependency fears, with concerns that demand for Apple products is slowing, and cyclical factors as growth concerns mount. I also noted that the Fed’s quantitative tightening policy, whereby it continued to reduce its balance sheet, at a time when interest rates were rising indicated that “more air is being taken out of the monetary balloon than at any time in the past decade.” There is no doubt that US monetary support for equity markets has been steadily withdrawn over the past 12 months.

But undoubtedly the biggest factor influencing markets was the outbreak of a trade war between the US and China – something which happened more suddenly than I anticipated because I thought that President Trump’s bark was worse than his bite. Although the G20 summit in December appeared to take some heat out of the US-China trade dispute, many of the issues which prompted the dispute in the first place remain unresolved. In what appears to have been a truce in trade hostilities, China made some trade concessions that prompted the US to hold off from raising tariffs on a wider range of goods. But China continues to skirt around the fact that the expropriation of copyright technology as a precondition for foreign firms to do business in the domestic Chinese market remains a live issue. To the extent that the trade ceasefire is conditional on eliminating this problem, we cannot say that trade concerns will not resurface in 2019.

Perhaps one of the biggest issues exposed by the trade war is that the rules-based architecture on which global prosperity has been based is threatened in a way we have not seen in many decades. The WTO exists as part of the institutional framework to prevent trade frictions from escalating, with 38 disputes brought before it this year alone. Unfortunately, the Trump administration is sceptical that the WTO will act in favour of the US and it continues to block appointments to the WTO’s Appellate Body which has been reduced from seven members to three. With the terms of two members set to expire in December 2019, this would reduce the Appellate Body below its necessary quorum unless new members are appointed and would mean that the WTO is no longer able to arbitrate in trade disputes. For the record, an analysis of WTO cases brought against China[1] indicate that “there are no cases where China has simply ignored rulings against it” – in contrast to the US which “has not complied with the WTO ruling in the cotton subsidies complaint brought by Brazil.” Bias? What bias?

But it is not only trade issues that have rattled markets. There is a growing trend towards economic nationalism evident throughout global politics which is leading to concerns that we have passed the high water mark of globalisation. Trump’s America First policy is a clear manifestation of this, as is Brexit. Indeed, perhaps one of the key trends to emerge in 2018 was the sense of drift in political leadership. I have talked at length about the political failures of Brexit, and I have serious reservations that politicians will see the light in the next three months which will avoid a hard Brexit having spent the past 30 months behaving irrationally. But French and German politicians are also facing increased pressure from an electorate which does not like what is on offer, whilst Italy’s populist policies have drawn the ire of the European Commission. This lack of leadership and inability to rise above local concerns to see the bigger picture is one of the biggest threats to the economy and markets as we look ahead to 2019.

In terms of some of my other 2018 predictions, I didn’t do altogether badly. Bitcoin prices collapsed, as I suspected they would; there was no war on the Korean peninsula and Donald Trump was not impeached. I was also right that Italy would not win the World Cup (though that was more to do with the fact they did not qualify for the finals). But when I did do the analysis in mid-year and tipped Germany to win, I did so only on the basis that the 18% probability assigned to their victory chances implied an 82% they would fail to win. Those are the sort of predictions I like – ones which can be both right and wrong at the same time. Happy New Year.

[1] Bacchus et al (2018) ‘Disciplining China’s Trade Practices at the WTO’, Policy Analysis 856, Cato Institute